You can reduce taxes and save for retirement by contributing to a tax-advantaged retirement plan. If your employer offers a 401(k) or Roth 401(k) plan, contributing to it is a tax-wise way to build a nest egg.
If you’re not already contributing the maximum allowed, consider increasing your contribution rate. Because of tax-deferred compounding (tax-free in the case of Roth accounts), boosting contributions sooner rather than later can have a significant impact on the size of your nest egg at retirement.
With a 401(k), an employee elects to have a certain amount of pay deferred and contributed by an employer on his or her behalf to the plan. The contribution limit for 2019 is $19,000. Employees age 50 or older by year-end are also permitted to make additional “catch-up” contributions of $6,000, for a total limit of $25,000 in 2019.
The IRS recently announced that the 401(k) contribution limit for 2020 will increase to $19,500; combined with the $6,500 catch-up contribution, that’s a total of $26,000 in 2020.
The traditional 401(k)
A traditional 401(k) offers many benefits, such as:
- Contributions are pretax, reducing your modified adjusted gross income (MAGI), which can help you reduce or avoid exposure to the 3.8% net investment income tax.
- Plan assets can grow tax-deferred — meaning you pay no income tax until you take distributions.
- Your employer may match some or all of your contributions pretax.
Take a look at your contributions. If your current contribution rate will leave you short of the limit, consider increasing your rate to get as close to the limit as you can afford. Keep in mind that your current paycheck will not be reduced by the full dollar amount of the increase in contribution because the contributions are pretax — so, income tax won’t be withheld on that amount.
Employers may also include a Roth option in their 401(k) plans. If this option is offered in your plan, you can designate some (or all) of your contributions as Roth contributions. Since such contributions are withheld on an after-tax basis, they don’t reduce your current MAGI. However, qualified distributions from a Roth 401(k) will be tax-free.
Roth 401(k) contributions may be especially beneficial for higher-income earners because their ability to contribute to a Roth IRA is limited. Contributions to a Roth IRA are reduced when an individual’s MAGI exceeds certain limits, as follows:
- Married-filing-jointly filing status: $193,000 in 2019; $196,000 in 2020
- Single filing status: $122,000 in 2019; $124,000 in 2020
Your ability to contribute to a Roth IRA in 2019 is eliminated entirely if you file your individual tax return as a married-filing-jointly filer and your 2019 MAGI equals or exceeds $203,000. The cutoff for single filers is $137,000 or greater. For 2020, these limits are increased for married-filing-jointly filers to $206,000 and for single filers to $139,000.
How much and which type
Do you have questions about how much to contribute or the best mix between regular and Roth 401(k) contributions? Contact us at KraftCPAs. We can discuss the best tax and retirement-saving considerations for your situation.